Question

Briefly describe some of the main theories of optimal capital structure for corporations generally.

Answer 1

An optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for a corporation is the balance between the ideal debt-to-equity range and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a corporation's risk generally increases as debt increases.

Capital Structure Theories basically deals with the question whether a change in capital structure influences the value of a firm or corporation. There are four approaches to this, I.e.,. net income, net operating income, traditional and M&M approach.

Capital Structure

Capital structure is the proportion of all types of capital i.e., equity, debt, preference etc. It is also be used as financial leverage or financing mix.It is also taken as the degree of debts in the financing or capital of a business firm.

In the capital structure of a corporation, broadly, there are mainly two types of capital i.e. Equity and Debt. Where as debt is considered a cheaper source of finance because the interest payments are a tax-deductible expense.The main objective of any financial decision is to maximize the shareholder’s wealth or increase the value of the firm.

The objective of finding an optimum capital structure leading to maximization of the value of the firm. If the cost of capital is high.

Net Income Approach is recommended by Durand and he was in the favor of financial leverage decision. According to him, change in financial leverage would lead to a change in the cost of capital. In short, if the ratio of debt in the capital structure increases, the weighted average cost of capital decreases and hence the value of the firm.

Net Operating Income Approach (Durand)

It was opposite to the Net Income Approach. It represents weighted average cost of capital remains constant. It believes in the fact that the market analyses firm as a whole which discounts at a particular rate which is not related to debt-equity ratio.

Traditional Approach

This was indefinite but it says that cost of capital is a function of the capital structure but it believes an optimal capital structure. It implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of the firm is maximum.

Modigliani and Miller Approach (MM Approach)

It has two propositions.

I: It says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would be same and it would not be affected by the mode of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings.

II. It says that the financial leverage boosts the expected earnings but it does not increase the value of the firm because the increase in earnings is compensated by the change in the required rate of return.

The detailed analysis of the optimal capital structure can help on the part of the cost of capital and increase the profits of the share holders.